China 'magnet' exerts strong pull on neighbors

South Korea, Taiwan, Japan hitched to powerful growth engine

SAN FRANCISCO (MarketWatch) -- The bull in China's shop is bellowing again this year, pulling a cartful of nearby Asian countries along with it. But investors should keep in mind that China's prowess leans on the spending power of U.S. consumers -- and that wheel is looking wobbly.

China's stock market rose 28.4% this year through May 15, with Korea up 10.5%, Taiwan climbing 12.4% and Japan advancing 11.1%, according to Morgan Stanley Capital International. Diversified mutual funds investing across Asia are up 15.4% on average in the same period, according to investment researcher Morningstar Inc.

The healthy returns reflect a flood of new investment into the region from U.S. buyers who see the potential payoff from Asian emerging markets outweighing inherent risks, and are convinced about Japan's economic recovery after more than a decade of fitful sputtering. U.S. stocks, in contrast, have gained 3.6% so far this year. In addition, Asia's robust trade with North America and Europe is fueling local investors.

And China, with its magnetic-like effect on trade and investment, has been the chief beneficiary.

"China is becoming one of the forces that drive the Asian regional economy," said Richard Gao, co-manager of the Matthews China Fund
MCHFX, -0.22%
"The purchasing power from China is growing rapidly. China has become the biggest export destination for Korea and Taiwan, and also accounts for a large portion of exports from Japan."

Great well for China

China's industrial output is in high gear. The country is a processing center, drawing materials and parts from countries across Asia. Manufacturers in South Korea, Taiwan and Japan have moved assembly lines to China, where consumer goods and electronics are much cheaper to make.

China needs this basic manufacturing business to fund its own pressing infrastructure needs. So China imports high-end technology and equipment from places like South Korea, Taiwan and Japan, plus resources from Southeast Asia and Australia. Components are then assembled into finished goods in Chinese factories and sold primarily to North America and Europe.

Taiwan's computer makers are a case in point. The industry, which accounts for 80% of the world market, has steadily shifted production to China. Last year, Taiwan's lone remaining notebook computer plant closed down, its tasks transferred across the Taiwan Strait. The empty facility in northern Taiwan will become a warehouse.

"It's a tremendous pull, reflected in the changing trade patterns," said Nicholas Lardy, a senior fellow at the Washington-based Institute for International Economics, assessing China's growing role as a factory to the world.

In turn, the world supplies China with cash for housing, highways, power plants, telecommunications systems and other projects that boost living standards -- and, not incidentally, its own nascent consumer class.

China's economic growth is making many Chinese wealthy, and Beijing wants to encourage them to spend. Long-term government policy envisions a country that is less dependent on exports and foreign investment in favor of self-reliant domestic growth.

"Eventually, China's huge domestic consumption will become the driving force for the overall economy," said Gao, the Matthews fund manager.

Chinese demand for property, financial services and high-end goods and services will surge, Gao added. "China is going to be one of the key importers of luxury products in the world," he predicted, adding that displays of affluence are increasingly visible even now. "Imports are moving up from basic materials and industrial products to luxury items."

To participate in this growth, Gao is tilting his portfolio toward consumer-led market sectors. One of the fund's top holdings is China Vanke Co. Ltd., a leading residential property developer traded on the Shenzhen stock exchange. Another major stake is given to China Life Insurance Co. (2628), a majority-owned government enterprise that Gao said is seeing rapid growth as state-guaranteed pension benefits have been reduced.

Double-edged sword

China is also headed up-market in both quality and type of goods it makes, said Peter Morici, a business professor at the University of Maryland. "You're going to see them move into durable goods -- cars, engines, air conditioners, appliances, industrial equipment, machine tools," he said.

Providers of technical products and engineering will continue to profit from the China trade, Morici added. Suppliers of commoditized products are in danger of being marginalized.

"Invest in companies that are selling high-end products and not commodity products," Morici said. "Whatever is easy to make, the Chinese will be doing soon -- if they're not already. They have cash to buy any know-how they want."

The biggest risk that China and its neighbors face is economic weakness in the U.S. Indeed, China's best customer is showing signs of stress. Higher interest rates are beginning to cool U.S. property markets and slow corporate profits, and soaring gasoline prices are contributing to inflation concerns. A weaker U.S. dollar only exacerbates the problem. China's currency is pegged to the dollar, so imports are costlier at the same time export growth may slow, squeezing Chinese manufacturers and state coffers.

"The key to understanding what's going on in China is to view China not as a small exporting competitor, but as an economy with a tremendous demand for infrastructure," said Curtis Mewbourne, co-head of emerging markets at bond-fund giant Pimco. "Neighboring countries are going to ride along."

But as with any business, a customer base that doesn't grow as fast as spending needs leaves only tough choices. China can't yet expect its own population to pick up the slack, nor can it look to other parts of Asia for comfort.

"The U.S. consumer is financing this," Mewbourne added. "As long as prices stay competitive and U.S. consumers feel confident, then it can continue."

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